Most of the lawsuits against Argentina in the New York courts ended in the Spring of 2016 through cash settlements with the major litigants.  The market is still digesting the lessons from this 15 years of bitter litigation.  That assessment may eventually conclude that

• playing the part of a death-grip holdout in a sovereign debt restructuring will probably pay off handsomely,
• obtaining a court injunction (a so-called pari passu injunction) preventing the sovereign borrower from paying its other external debt without making a “ratable” payment to holdouts is an essential element to a winning holdout strategy, and
• creditors prepared to accept the sovereign’s restructuring offer are at risk of (i) looking anemic (at best) or incompetent (at worst) when litigious holdouts realize significantly better recoveries and (ii) seeing the debt instruments they accept in the restructuring become the object of ratable payment injunctions. In the Argentine case, the sovereign ceased making payments on its new bonds altogether rather than stomach the prospect of paying off holdout creditors.

In a future sovereign debt workout, these ingredients could produce an algae bloom of holdout creditor behavior.  Indeed, Venezuela, whose bonds trade at levels suggesting a high probability of default, already casts a cold and inky shadow over the sovereign debt market.

Remedies

Over time, this situation may correct itself.  The U.S. federal courts may in future cases clarify that a sovereign’s practice of paying some creditors but not paying others, by itself, does not breach a pari passu covenant or warrant the issuance of a ratable payment injunction.  Such decisions could confine the Argentine pari passu precedent to the aggravated facts of the Argentine case.

Following the issuance of the ratable payment injunctions in the Argentine case — and as a direct response to the judicial holdings in that case — the market moved to embrace a revised version of the pari passu clause in sovereign bonds.  This new version expressly disavows the ratable payment interpretation given to that provision by the New York courts.  In addition, the market is quickly adopting new versions of collective action clauses that will make it harder for holdout creditors to game the system in future workouts.

The problem is time.  These remedies may take years or decades before they will effectively disarm the pari passu weapon that has been forged in the furnace of the Argentine litigation.  In the meantime, what can the architects of sovereign debt restructurings under New York law do to address the perfectly legitimate concern of participating lenders that they not become the victim of holdouts prepared to wield this new weapon against their erstwhile fellow lenders?

Strategic Options

We see three possible approaches.  Much will depend, however, on the specific facts of the sovereign issuer’s debt stock and the legal terms of its outstanding debt instruments.

Issue Non-Benchmark Securities.  A pari passu clause promises that the debt instrument containing the clause will rank equally with some other category of the issuer’s financial undertakings.  We call these other categories Benchmarks.  The Benchmark is often a defined term in the debt instrument.  It could be “External Debt” or “Publicly Issued External Debt” or “Indebtedness” or just simply “Obligations.”  The risk of a pari passu injunction should disappear if the sovereign can issue debt instruments in the restructuring that fall outside of the relevant pari passu Benchmark category.

Exit Consents.  If the terms of the sovereign’s existing bonds permit it, the sovereign could seek as part of the restructuring the amendment of those instruments to remove entirely the pari passu clause in the old bonds or to specify that the only remedy for a breach of that clause is acceleration and money damages (not an equitable remedy such as specific performance or an injunction). Amendments to debt instruments solicited from holders just prior to those holders exchanging the instruments for new bonds are referred to as “exit consents.”  The consent to the amendment is given just prior to the holder’s exiting from the instrument.  An exit consent of this kind, if permitted under the terms of the sovereign’s old bonds, should neutralize the pari passu threat those instruments will pose when some are left in the hands of holdouts.

Cryonic Solution.  When sovereigns issue new bonds in a debt restructuring in exchange for old bonds, they generally cancel the old bonds immediately upon the closing of the deal.  But they don’t have to.  The old bonds could be left in cryonic suspension and lodged with a custodian trustee.

The custodian of the old bonds would be instructed not to enforce those instruments or join in any effort to accelerate them.  The custodian would, however, be given standing instructions to assert a claim — based on the pari passu clause in the old bonds — for a ratable payment if a holdout succeeds in extracting a preferential recovery from the issuer if (but only if) the court had previously interpreted that pari passu clause to require ratable payments.  If any payments are received under the old bonds, the custodian is instructed to apply these amounts toward payments falling due under the new bonds.

Leaving the old bonds alive but in a safe pair of hands would serve these purposes:

• If a holdout succeeded in obtaining an Argentina-style injunction preventing payments on the new bonds without making ratable payments on the old bonds, the issuer could cease paying the new bonds directly and channel the money as a partial payment of the old bonds. Most of that payment will flow through the hands of the custodian and be applied to the new bonds.  A portion, however, will have to be paid to the holdouts.
• If a holdout successfully employs a pari passu injunction to extract a preferential payment from the issuer, the holdout will thereby expose itself to an equivalent ratable payment claim by the custodian of the old bonds. The ratable payment interpretation of the pari passu clause thus devours its own maker.
• If the terms of the old bonds treat those instruments in the hands of the custodian as outstanding for voting purposes, the custodian may be able to block any attempt by the holdouts to accelerate the old bonds.

The principal legacy of the Argentine litigation will be to render sovereign debt restructurings under New York law more difficult.  The history of sovereign debt workouts over the last 40 years, however, shows that whenever leverage tilts strongly in favor of either the creditors or the sovereign borrowers, countermeasures are devised to render the advantage temporary.  We believe that countermeasures will be found to neutralize the threat of pari passu injunctions of the kind fashioned in the Argentine litigation.

This post comes to us from Lee C. Buchheit, a partner in the New York office of law firm Cleary Gottlieb Steen & Hamilton, and from Mitu Gulati of Duke Law School. It is based on their article, “Restructuring Sovereign Debt after NML v. Argentina,” which is available here.